Understanding Foreign Exchange Rates (Cambridge (CIE) IGCSE Economics): Revision Note

An introduction to exchange rates

• An exchange rate is the price of one currency in terms of another e.g. £1 = €1.18

  • International currencies are essentially products that can be bought and sold on the foreign exchange market (forex)

• Exchange rates are important because they determine how much of a foreign currency you can get when you exchange your own currency — which affects trade, investment, tourism and international finance

Reasons for buying and selling foreign currencies

• Countries, businesses and individuals buy and sell foreign currencies for many reasons

• The demand and supply of different currencies in the foreign exchange market is influenced by the following:

1. Trade in goods and services

• Importers need to buy foreign currencies to pay for goods and services from other countries

• Exporters, on the other hand, often receive payment in foreign currencies and exchange them into their own currency

2. Speculation

• Currency traders (speculators) buy and sell currencies to make a profit from changes in exchange rates.

  • For example, if a trader expects the euro to rise in value, they might buy euros now and sell them later at a higher rate

3. Government intervention

• Governments and central banks may buy or sell their own currency to influence its value

  • This is called exchange rate intervention and is often done to help control inflation, support exports, or maintain economic stability

4. Profit, interest and dividend payments

• When businesses or investors earn profits, interest, or dividends from other countries, they often need to convert the foreign currency earnings into their own currency

5. Workers’ remittances

• Many people work in foreign countries and send money home to their families (remittances)

• These remittances involve converting the worker’s earnings from the currency they are paid in into the home country’s currency

6. Investment in capital goods

• Firms and governments may invest in machinery, buildings, or infrastructure from other countries

  • To do this, they need to buy the seller’s currency, which increases demand in the foreign exchange market